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volume 11 issue 3

Forecasting Fund

Manager Alphas:

impossible The just takes longer

june 2008 b

executive editors authors

Ronald N. Kahn M. Barton Waring

415 597 2266 phone Chief Investment Officer for Investment Policy and Strategy, Emeritus

415 618 1514 facsimile

Barton Waring ran BGI’s Client Advisory Group—delivering leading-edge

ron.kahn@barclaysglobal.com

investment strategy and policy advice to the firm’s clients—from 1996

until his recent decision to retire, and continues in an advisory capacity

Matthew H. Scanlan

415 597 2716 phone in his new emeritus role. He has published more than two dozen articles

415 618 1069 facsimile on surplus asset allocation, manager structure optimization and risk

matthew.scanlan@barclaysglobal.com budgeting, and defined contribution/individual investor investment

strategy. Barton serves on the Editorial Advisory Boards for The Journal

of Portfolio Management, the Financial Analysts Journal, and The Journal of

editor Investing. He received his BS degree in economics from the University

of Oregon, his JD degree from Lewis and Clark College, with honors,

Marcia Roitberg

415 597 2358 phone and his masters degree in finance from Yale University.

415 618 1455 facsimile

marcia.roitberg@barclaysglobal.com Sunder R. Ramkumar

Client Advisory Strategist

advises our strategic clients on asset allocation issues, and is responsible

for developing optimal plan-level investment solutions. Sunder has also

conducted research for BGI’s advanced active equity strategies, and advised

on new product development for defined contribution plans. He received

an MS in management science and engineering with a concentration in

finance from Stanford University, and has a BE in mechanical engineering.

He is also a CFA charterholder.

We would like to express our appreciation to Laurence B. Siegel and Steven Thorley.

Their wise comments and suggestions helped us to significantly improve this article.

number 2 issue of the Financial Analysts Journal. It is reprinted here

with permission from CFA Institute, © 2008 CFA Institute. The FAJ

can be found online at www.cfapubs.org.

c InvestmentInsights

Forecasting Fund

Manager Alphas:

The impossible just takes longer

Table of Contents

Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

june 2008 1

EXECUTIVE SUMMARY

Many investors (plan sponsors) balk at the suggestion of making explicit alpha

forecasts before hiring active fund managers. But in fact, fund manager alphas

can and should be forecast.

Active management is a zero-sum game (negative 4. The breadth of the portfolio, representing the

sum after fees and costs) where the performance number of independent active management deci-

of all active managers is distributed around—above sions made per year by the portfolio manager.

and below—the benchmark. Therefore, to win con-

5. The transfer coefficient, or implementation

sistently, a manager must have exceptional skill,

efficiency, of the portfolio, expressing the

enough to beat the others playing the game. Not

performance drag from constraints.

only this, but the plan sponsor is selecting managers

from this same zero-sum distribution, and so must 6. The expected active risk of the portfolio.

also have special skill—at identifying skillful active

7. The level of fees.

managers to beat the benchmark. So two levels

of skill, one at the manager level and one at the These variables, particularly the first two, require

sponsor level, are required for active management careful thought and research. Just as sponsors

to be successful. expect fund managers to be thorough in evaluating

stocks, so too sponsors must thoroughly evaluate

Both sponsor skill and fund manager skill can be

fund managers to develop meaningful forecasts.

quantified and incorporated into an explicit alpha

forecast in the framework developed in this article. Investors should be encouraged to use the above

By combining two equations set forth by Richard method for explicit alpha forecasting because it

Grinold—the “fundamental law of active manage- brings discipline and structure to the process of

ment” and a variation on the “forecasting equation”— building portfolios of managers. Alpha forecasts

one can derive a formula for building an alpha made using this approach will be internally con-

forecast out of seven elemental parts: sistent, clearly communicable and defensible.

Additionally, robust alpha forecasts are required

1. The sponsor’s forecast of the manager’s skill

for manager-structure optimization. Optimized

relative to peers.

portfolios of managers will differentially weight

2. The sponsor’s self-assessment of his ability those managers that have the highest alphas and

at selecting good managers. the lowest active risks, a result which almost never

happens from intuition-driven weighting schemes.

3. The variation (distribution) of manager skill

across the manager peer group.

2 InvestmentInsights

Introduction

when it is about the future.

e expect the premise of this article—that one can and should fore-

cast manager alphas—to be challenging for many readers. In our experience,

many investment professionals simply do not believe that fund manager alphas

can be meaningfully forecast. There is some irony in this reaction: Our observation

includes many, if not most, of those people whose actual daily work is dominated

by the task of selecting and monitoring active fund managers.

—Attributed to Niels Bohr 1

Selecting active fund managers and building portfolios the sponsor as it is for the fund manager: to maximize

of them is an exercise in active management com- expected portfolio alpha (net of fees) at an acceptable

pletely parallel to the work of conventional active fund level of active risk.2 And some forecast of future per-

managers in selecting securities. The only difference formance seems essential to either task.

is that the securities selected are not “atomic” securities

As its point of departure, this article relies heavily

(the individual securities out of which fund managers

on Waring, Whitney, Pirone, and Castille (2000)

build their portfolios) but “molecular” securities, the

and Waring and Siegel (2003). These articles discuss

portfolios themselves, which are built up from many

methods for building portfolios of active fund man-

atoms. And when a sponsor builds a portfolio composed

agers. The Waring and Siegel article, in particular,

of these molecular securities, the usual prescriptions

promised further improvements in these forecasting

for active portfolio construction still apply. The objec-

methods. It is that promise that we mean to honor here.

tive function for portfolio optimization is the same for

1 araphrased from www.quotationspage.com, accessed on October 11, 2007. The origin of this quote is not precisely

P

known. It has also been attributed to the Danish-American comedian and pianist Victor Borge.

2 e use the term “sponsor” throughout, but we mean the article to fully and generally apply to all investors—plan

W

sponsors, foundations, endowments, individual investors, and anyone else facing the task of evaluating professional

investment fund managers.

june 2008 3

Why forecast alphas? not require any decision other than whether to hire or

Although many sponsors try mightily to avoid making not hire the fund manager who appears to be “best” in

specific forecasts of manager alphas, we would point out a beauty contest parade of applicants—which is today’s

that the sponsor’s holdings of active managers already dominant method of selection. Someone with such a

contain embedded forecasts of the alpha for each man- mind-set might naturally wish to avoid claiming much

ager. One simply needs a specially fitted optimizer—a credit for success or being held accountable for failure,

“reverse optimizer”—to tease the alpha forecasts out.3 and the beauty contest process supports such an aspira-

Such an optimizer assumes that the sponsor thinks of its tion admirably! We could posit other explanations for

portfolio of managers as optimal, which in the context of current practice, but the conclusion is the same: Practical

active manager selection means that the sponsor portfo- results could be much improved by either (1) carefully

lio must maximize the expected overall portfolio alpha at applying skill to the task of making alpha forecasts or

a given level of overall portfolio active risk. The reverse (2) giving up on the use of active management and

optimizer backs out the alpha forecasts that would be defaulting entirely to inexpensive index funds.

required for the portfolio of managers to be optimal. We

As we will see, one can, in fact, build portfolios of securi-

have conducted this exercise with many sponsors’ port-

ties and hire active fund managers successfully—that is,

folios, and we are often surprised by the huge expected

with an ex ante expectation of a positive expected alpha—

alphas that are implied by the large holdings of some

given certain conditions. The finance professors who taught

of their active managers (and particularly by the large

us that “you can’t beat the market” were only correct as

holdings of those managers who take a lot of active risk).

far as they went. Let’s go further.

But our main point is not that the implied alpha forecasts

are sometimes impossibly large; our point is that they

are there. One cannot build a portfolio of active managers The Two Conditions for Success

without making alpha forecasts for each manager, either in Active Fund Management

explicitly or implicitly. Doing so explicitly is much better. Few finance professors would assert today that markets

Explicit alpha forecasts can give the sponsor more mean- are perfectly efficient. Most of them (as well as most prac-

ingful guidance regarding which fund managers to hire, titioners) would agree that the markets generally approach

whether to fire or retain a manager, and how to weight efficiency without attaining it. It is in the imperfections—

the managers in the portfolio. And such forecasts are those bits of price-relevant information or knowledge that

essential to a well-optimized portfolio of fund managers. are not yet efficiently and fully impounded in prices—that

opportunities for above-market returns might be found.

Why Do Sponsors Resist Making But we must be careful here. Many investors express the

Explicit Alpha Forecasts? belief that one should always choose active fund managers

Reluctance to make alpha forecasts may reflect an underly- (instead of index funds) in any market that is inefficient.

ing skepticism that any fund managers are capable of But this belief is seriously in error. Some inefficiency

delivering positive alpha consistently. After all, profession- in the relevant market is a necessary condition for the

als in the sponsor organization would have been lectured expected success of active fund management, but it is

repeatedly during their formal finance education that “the not a sufficient condition: Even the most inefficient market

market is efficient” so “you can’t beat the market.” Perhaps imaginable—say, a “frontier” emerging market country—

the real reason they continue to hire active fund managers is still a zero-sum game, in which the returns of all active

is that their boards and committees expect them to, not players sum to the return of the market itself. (That is, an

because they believe doing so will add value. If the spon- index fund of that market will have mean performance,

sor’s board or committee expects the sponsor to hire and before fees and costs, with some active players beating it

retain active fund managers, but the sponsor secretly does and some losing to it.) More than inefficiency is required

not believe that managers can be successfully chosen for active management to beat an appropriate competing

ex ante, the sponsor might prefer a process that does index fund.

3 Specifically, what is needed is an active risk–active return optimizer that is capable of running in reverse. See Waring

and Siegel (2003).

4 InvestmentInsights

What more is required for predictable, rather than random, n Some degree of inefficiency in the relevant market, and

success? The fund manager must either know something n Above-average skill on the part of the fund manager.

that others in the market do not know, or understand

The first condition is easy for most people to accept.

more clearly something that is also known to others but

The second can be accepted as a general proposition

not as well understood by them. The active manager has

by most, in the sense that some managers must have

to have an edge over the other players in the market. For

above-average skill or the Warren Buffetts of the world

short, we call this edge “skill.”4 Formally, we refer to this

would have no honor. But it causes angst if we try to get

skill as a “positive information coefficient.”5 Formally,

specific: From a population of managers who obviously

the information coefficient is the correlation of a man-

do not have above-average skill on average, how can one

ager’s forecasts with subsequent realizations, and it is

identify which managers do have special skill?

simply because they are active—ever. And hiring active fund

managers without making and using explicit expected alpha

forecasts for each of them is definitely suboptimal.

a forward-looking concept: A fund manager has a positive Let’s turn to the perspective of the hiring sponsor.

information coefficient if the manager can, more often

than not, predict which securities will have positive The Two Conditions for Employing

alphas (and what their magnitude will be) during the Active Fund Managers

upcoming period.6 What must a sponsor believe before deciding to hire

Such special skill is the ingredient for fund manager active fund managers—that is, if the sponsor wants to

success that is in limited supply and that is also difficult hire a portfolio of active fund managers having a collec-

for the sponsor to assess. Investors do not want to play tively positive expected alpha?

the great zero-sum game—choosing to actively manage First, the sponsor has to believe that successful active

a portfolio rather than passively hold its benchmark— management is, in the abstract, possible. Although tra-

unless they believe that they have skill at identifying ditionally this belief has been pooh-poohed (“you can’t

securities or other investment positions that will earn beat the market”), we hope we have been persuasive in

a positive alpha in the coming period. the prior section that this is, in fact, possible (and we

So, the Two Conditions required for a specific active fund argue for it in greater detail later). So, the sponsor must

manager to have a positive expected alpha are

4 Below-average managers also have some of what would ordinarily be called “skill,” but not enough to be valuable.

“Skill” in the specialized sense that we use it here is the ability to win a zero-sum game. It thus implies an ability

to add value, which is not ordinarily something required when the term is used in other contexts. A below-average

doctor, for example, is not only skillful but valuable; because he or she is not playing a zero-sum game, any

contribution is a plus. But a below-average active manager has negative economic value. See, for example,

Siegel (2004).

5 “Information coefficient” is the preferred term for skill in the literature of finance; see Grinold and Kahn (2000a,

2000b).

6 fund manager who can predict which securities will have negative alphas and predict what their magnitude

A

will be also has skill (a positive information coefficient). This information is profitable if used as part of the

selling discipline of a long-only manager or for selling short if the fund manager is allowed to do so.

june 2008 5

accept the first set of the Two Conditions as expressed in number are going to get a C. The bell curve, or normal

the prior section, under which one can believe that good distribution, does a great job of lending intuition to the

fund managers might, in fact, exist. A more intuitive way notion that some of us are more skillful than others, and

to express this is that the sponsor must first believe that it is logical to assume that this distribution is a decent

some “good” fund managers do exist. descriptor of skill or talent in any endeavor—including

active management.

Second, the sponsor has to be able to move from the

general to the specific: It must believe that it has the skill What does it mean to have skill in active management?

to identify fund managers that have skill—that is, the Because the average player in the markets is fairly well

skill to differentiate between the good, the bad, and the educated and intelligent, the skill levels needed are those

indifferent fund manager, before the fact.7 So, the key that stand out in a tough crowd. To be considered skillful

to success for sponsors is also skill. in this particular sense requires more than merely being

smarter than the average human being or even being

Skill more skillful as an investor than the general population.

In short, two very separate levels of skill are required: To have an expectation of being a successful active man-

The sponsor needs to have skill at identifying fund ager, one must have skill that is above average relative to

managers who have skill at picking securities and the skill of others who are “playing the game” of trying

other investment positions. to beat the market. That is, one must be above average in

an above-average domain. If active management were a

Across the universe of players, skill averages to a value

zero-sum game, then perhaps half of those actually play-

of zero. The average investor gets the market return,

ing (that is, of those thinking themselves good enough to

which is a way of summarizing Sharpe’s wonderful 1991

give it a try) would have sufficient skill. But because it

article, “The Arithmetic of Active Management,” in which

is a negative-sum game, only something less than half of

he so eloquently showed that the market is a zero-sum

the players will be skilled enough to win after covering

game. More completely, the market is a negative-sum

their fees and embedded costs (and to win by enough to

game, with the negativity reflecting the necessary impact

justify the additional risk taken on).8

of fees and costs incurred in the effort of playing the game.

The good news for sponsors that plan to hire active man-

But not everybody is average! In fact, in nearly any skill-

agers, however, is that skill levels do, in fact, vary widely.

based activity, whether it is buying stocks or figure skating,

The market is a mechanism by which the more skilled can

there is a wide distribution of skill levels among the

profit at the expense of the less skilled. So, good players

population engaged in the activity. Most of us have

almost certainly must exist, both at the fund manager level

recognized, ever since some junior high school teacher

and at the sponsor level. A sponsor with skill at identifying

explained she was grading “on the curve,” that some few

fund manager skill has a serious edge.

are destined to earn an A and equally few will earn an

F, that more will earn a B or a D, and that the greatest

7 The sponsor’s skill includes the collective skill of the board, staff, and any consultants or other advisers used in the

fund manager selection process. Real skill may exist but be diluted in practice by the governance and decision-making

structure. A sensible effort to reduce that dilution might include a board decision to turn the skill-based decisions over

to professionals on their staffs selected for that skill.

8 I n light of the daunting odds of the game, the reader might wonder why so many active manager mandates are still

granted by plan sponsors. One answer is the pervasive human tendency toward overconfidence, which has been a

major topic among behavioral finance researchers. Much of the literature on overconfidence proceeds from the obser-

vation that trading volume is way too high to be explained by rational models (see, for example, Odean [1998, 1999];

Statman, Thorley, and Vorkink [2006]). Those who choose to index are admitting that they possess only average (or

worse) skill, and what plan sponsor is going to admit that?

6 InvestmentInsights

Comparing Techniques for alpha (summed across the managers) at a given or

Building Portfolios of Managers “acceptable” level of active risk (also taken collectively

Today’s most common manager selection approaches across the managers). To build such a portfolio, expected

almost never include an explicit alpha-forecasting pro- alpha must be specifically estimated for each candidate

cess. The widely used beauty pageant approach tries to fund manager. The method has become known as “man-

pick the “best” manager, but little or no effort is made to ager structure optimization.”10

quantify specific expectations for future alpha (unless one

Soon after those publications, Kahn (2000) showed that

gives credit to the effort to sort out future performance by

in an ideal optimized portfolio of managers, the ideal

studying past performance, a dangerous credit to extend).

manager weights, w*Mgr , would be proportional to the

Of course, there is a hope that the manager chosen will,

manager’s expected alpha,

at a minimum, outperform the appropriate benchmark.9

active variance, 2

aMgr , divided by expected

Mgr :

After all, staff members, committees, and boards do take q

their tasks seriously, and if the “best” manager from this

process were not even expected to outperform an index w*Mgr ~

aMgr . (1)

2

fund, then one supposes (or at least hopes) that the man- q Mgr

ager would not be chosen.

Equation 1 is algebraically equivalent to saying that the

Not only is the list of managers selected important, but

total “bet”—that is, the optimal manager weight times

so are the weights given to these managers. In today’s

the manager’s active risk—is proportional to the man-

practice, manager weights are often dictated by the desire

ager’s expected information ratio, IR:

to fill out “style boxes,” a method that assigns weights

based on the styles (i.e., multifactor beta characteristics)

w*Mgr

aMgr = IR. (2)

of the fund managers. So, managers are selected in a

q Mgr ~

series of beauty contests, and then the portfolio is built qMgr

by investing in those managers in amounts sufficient to

fill out each style box’s required weight. The perspectives of Waring et al. and of Kahn show—and

for the same reason—that expected fund manager alpha

In contrast, Waring et al. (2000) provided a different

is one of the most important determinants of the ideal

method. The authors extended the active portfolio con-

weights of managers in the portfolio.

struction approach of Grinold and Kahn (2000a) up one

level—from the fund manager’s problem to the sponsor’s So, it does not make sense to hire active fund managers

problem. They showed that the ideal portfolio of managers simply because they are active—ever. And hiring active

is an optimized one that maximizes overall expected fund managers without making and using explicit expected

alpha forecasts for each of them is definitely suboptimal.

9 More precisely, the expectation is that the active manager will outperform an index fund managed to the same bench-

mark after adjustment for the difference in fees.

10 This method includes mechanisms for controlling “misfit risk.” Sponsors generally, and appropriately, impose an implied

constraint that the sum of all the sponsor’s multifactor beta exposures (asset classes and styles, usually), taken across

all the fund managers and other subportfolios, must equal the sponsor’s current target asset allocation policy (strategic

plus current tactical policy, if any). Misfit risk is the risk that comes from violations of this constraint—an overexposure

to value, for example. This constraint is important to sponsors, and to operate under it, fund managers are constrained,

in turn, to stay relatively close to their (disclosed) benchmarks. Market-neutral, long–short managers, whose forward-

looking benchmarks have zero multifactor beta weights, are also constrained to stay that way, at least on average over

time. Thus, the result of a manager structure optimization is an optimized improvement over the use of simple style

boxes, ensuring not only an optimal tradeoff of alpha for expected active risk, but also that the sponsor’s benchmark

is maintained.

june 2008 7

Moreover, not surprisingly, the expected alpha will The prescription is only slightly more helpful if the fund

also have an important impact on the weight given manager’s data do pass the t-test. If a 95% confidence

to each manager selected. Thus, optimal portfolios of interval is used, there is still at least a 5% chance—and

fund managers require specific estimates of expected in reality, it is much greater—that the strong performance

fund manager alpha. was simply a random occurrence rather than the result

of skill. As we said, getting information out of historical

Do Historical Alphas Help alpha data isn’t easy.

Forecast Future Alphas? The best conclusion is that passing the t-test provides only

The regulator’s required disclaimer to the effect that evidence of skill, not proof. Therefore, although the fact

“past performance is no guarantee of future performance” that a manager’s historical alphas have passed a t-test is

is correct, but it can be overgeneralized to mean that surely admissible (in the technical sense) in the process

historical data never contain any useful information. of evaluating fund managers, it is by no means conclusive

That interpretation is not true; but even so, with rare as to the manager’s skillfulness. The sponsor should also

exceptions, whatever information does happen to be look at fundamental data. So, whether the data pass a

in the data is extremely difficult to ferret out with t-test or not, historical data should be relied on much less

any confidence.11 than is found in current manager selection practices.

One method of extracting information from the data might Here is another way to look at the historical data issue:

be to use a statistician’s tools for separating skillful from If real information in the historical data is so difficult to

unskillful historical performance. A difference-of-means tease out that a sponsor is not going to be successful in

test (which provides the familiar t-statistic) could be used the effort, then any portfolio of fund managers constructed

in an attempt to reject the null hypothesis that the histor- by the sponsor on the basis of those data is simply going to

ical alpha of the fund manager has a zero mean (before have random performance around the benchmark—that

fees). Few managers’ data sets will “pass” such a skill is, zero mean alpha before fees and costs, and negative

test, however, because by construction, passing generally mean alpha after fund manager fees and costs. A port-

requires something like a 95% confidence level.12 folio based on such data, without skill, is a “closet index

This situation is a real challenge to the widespread prac- fund”—and one with high fees and high tracking error.

tice of giving heavy weight to historical fund manager It will deliver its beta, but it will only outperform or

alpha. If one cannot claim with reasonable certainty that underperform randomly; its realized alpha over time

the fund manager’s mean historical alpha is significantly will simply be Brownian motion—pure randomness

different from zero—if it does not pass the t-test—the with a negative bias.

statistician has a strict prescription for these sponsors: Such a portfolio, and sadly it is the norm, creates the

Simply throw the historical data away and completely expectation that the efforts of the sponsor will result

disregard them when considering the manager’s future in true added value. But, in fact, it confuses motion

alpha. Only other data, most likely fundamental data, with forward progress. A sponsor using historical data

can be fairly considered in this event. to project future alpha could reduce its active risk and

improve after-fee performance simply by moving to an

all-indexed implementation.

11 Numerous studies have examined the persistence of mutual fund performance; see Grinold and Kahn (2000a) for a

survey. Although the findings have been mixed, because of differences in study period, time horizon, and methodology,

the correlation between past and future performance generally appears to be fairly low. Even optimistic studies indicate

that the probability of a past winner remaining a winner is only about 60%.

12 The probability levels actually used as boundaries for passing such a test (or, more properly, for rejecting the null

hypothesis) depend on both the specific type of test and, to some extent, the judgment of the statistician establishing

the confidence boundaries to be used.

8 InvestmentInsights

portfolio’s expected alpha,

In contrast, if the portfolio of fund managers is assembled

optimally, with skillful (after-fee) alpha forecasts that active risk,

a, to the portfolio’s pure

. According to the fundamental law, the

q

do not rely inappropriately on uninformative historical expected information ratio is a function of the information

(or other) data, it will have a positive expected alpha coefficient, IC, and of selection breadth, Br. In mathematical

at the total portfolio level, a characteristic that index notation (with the expectations operators omitted from

funds obviously cannot have. Such an outcome can be the variables to simplify the display), the law is

achieved only by a sponsor that has and uses skill in

identifying fund manager skill. There is no formula; IRMgr| Mgr =

aMgr

there is no recipe; there are no shortcuts.

q Mgr

Skill necessarily implies the exercise of informed judg- = ICMgr| Mgr BrMgr| Mgr . (3)

ment. So, at some point, someone must make a claim of

skill and be prepared to try to deliver on that claim. This

We have used a separator in the subscript notation, as

person, or group of persons, needs to step up to the plate,

in ICMgr|Mgr , to help us keep track of, first, which player

make an informed but judgment-based forecast for the

it is (the fund manager or the sponsor) that the estimate

alphas of the candidate fund managers, and be account-

applies to and, second, which player is making the estimate

able at the total portfolio level for being more right than

or is responsible for the result. This example, ICMgr|Mgr ,

wrong. We now present a methodology for sensibly

means “the information coefficient of the manager in

approaching this task.

the view of the manager” (a self-assessed information

coefficient). If it were ICMgr|Spon , it would mean “the

information coefficient of the manager in the view of

Forecasting fund the sponsor” and clearly could differ from ICMgr|Mgr .

manager alphas Ditto for other variations.

Two useful relationships are described in the active man-

agement literature that can be used to guide the search In plain language, then, Equation 3 reads: “The expected

for a method of forecasting alphas. The first is the fun- information ratio of a fund manager’s active portfolio, in

damental law of active management, which we shorten the view of the manager, equals the expected informa-

to the “fundamental law.” The second is often called the tion coefficient, or skill, of the manager (as assessed by

“forecasting equation.” Both are attributed to Grinold the manager) times the square root of expected breadth

(1989, 1994).13 of the portfolio.”

Not surprisingly, both of these relationships are closely In Equation 3, the information coefficient represents the

tied to skill, and given the two levels of skill required fund manager’s skill at forecasting the returns of the

in our problem, we’ll find this to be useful. We’ll review individual securities that may go into his or her portfolio.

these relationships in the context of this paper’s task It is more formally defined as the expected correlation

and then look at how to use them, or variations of them, coefficient between forecast returns and subsequent

to formally forecast fund manager alpha. realized returns.

Relationship No. 1: (uncorrelated) bets that the fund manager makes in the

The Fundamental Law measurement period—usually a year. It is a measure of

The fundamental law is most often stated in a form that the extent to which active bets are diversified or, more

shows the relationship of a fund manager’s expected precisely, the extent to which forecasting skill is applied

portfolio information ratio to certain of its key determi- broadly among securities (or other investment positions).

nants. The expected information ratio is the ratio of the

june 2008 9

The breadth term in the fundamental law implies that the Relationship No. 2:

most consistently successful fund managers are those The Forecasting Equation

who apply their forecasting skill widely over a large The forecasting equation is

number of independent bets. As Grinold and Kahn noted, (6)

the fundamental law boils down to a mandate to “play

aSec|Mgr = ICMgr|Mgr q Sec|Mgr zSec|Mgr .

often, and play well.”14 Equation 6 means that the expected alpha of a security in

the view of a portfolio manager is the product of the skill

Although the original fundamental law was derived

of the manager, times the active risk (standard deviation

in the absence of constraints, real-world portfolios are

of residuals) of the security, times the z-score of the

rarely unconstrained. Grinold and Kahn (2000a) dem-

security—all as assessed by the manager. Grinold’s

onstrated that the long-only constraint severely limits

purpose in developing this relationship was to help fund

fund managers’ abilities to implement their insights and

managers readily form forecasts of alpha for individual

results in a significant performance drag when such

securities (not alphas for the fund manager portfolios

portfolios are compared with a similarly optimized but

themselves, consisting of many securities).

unconstrained portfolio. Thus, the fundamental law can

be expanded to include an additional term, referred to as The z-score is a standardized variable that reflects the

the “transfer coefficient,” that reflects the performance fund manager’s evaluation of the “goodness” of a security

drag or inefficiency resulting from constraints.15 Stated (or in the application we describe next, the sponsor’s

another way, the transfer coefficient is the ratio of the evaluation of the extent of the fund manager’s skill).

information ratio of the portfolio to the information ratio Mathematically, the z-score has a normal distribution

of a portfolio based on identical information but imple- with a mean of 0 and a standard deviation of 1. Thus,

mented without any constraints. “buys” would be assigned a positive z-score and “sells”

a negative z-score. A z-score of 1, for example, suggests

So, the fundamental law, modified to incorporate the

that the security is believed to be 1 standard deviation

transfer coefficient, TC, and subscripted to apply to

better than average; it would thus be better than roughly

its ordinary perspective, that of the fund manager, is

five-sixths of all stocks being assessed by that fund man-

ager. Rarely would a security earn a z-score of 2, and a 3

IRMgr| Mgr =

aMgr|Mgr would be a one-in-a-thousand event. If a fund manager

q Mgr|Mgr (4) had no view on a security, the manager would assign it

a 0 z-score, implying no alpha expectation.

= ICMgr|Mgr BrMgr|Mgr TCMgr|Mgr . (4)

The security’s residual or pure active risk ( Sec|Mgr ) is

q

the standard deviation of the security’s monthly or annual

We are interested in forecasting alphas, so we restate the

alphas over time. The more volatile the security’s alpha,

fundamental law to focus on the expected alpha term by

the greater the opportunity to profit from its price moves—

multiplying both sides of Equation 4 by expected active

for example, by buying it on its upswing and selling it on

risk (moving to the right side of the equation):

q its downswing. Thus, a higher volatility translates into a

higher expected alpha, for a given level of skill.

Mgr|Mgr = ICMgr|Mgr Br Mgr |Mgr TCMgr|Mgr Mgr|Mgr . (5)

a q This forecasting formula is Bayesian, in essence. It begins

with a raw forecast—that the security alpha is the product

So far, the point of view has been that of the manager,

of the standard deviation times the z-score assigned to

but the sponsor has not been forgotten. We will come

the security by the manager—thus, for the moment,

back to the sponsor’s role in a moment.

14 In this context, by “play often,” Grinold and Kahn (2000a, p. 162) mean that the skillful investment manager should make

many specific, small, and unrelated bets—not that the manager should simply incur high turnover by betting frequently.

15 Clarke, de Silva, and Thorley (2002) developed this important generalization of efficiency.

10 InvestmentInsights

treating this result as if it were a perfect forecast. The requires a self-assessment of the sponsor’s skill at this

formula then modifies this raw forecast, correcting it task. To do this, we tie together a new form of the fore-

back toward the null hypothesis (or “prior”) that the casting equation with a form of the fundamental law to

unconditional forecast is zero by multiplying it by the complete the description of the fund manager’s expected

skill term—the manager’s own information coefficient. alpha at the level of the manager’s total portfolio.17

The “Alpha-Builder”

manager skill, the forecasting equation looks like this

Forecasting Framework (see Appendix):

We now have the building blocks for a very complete

forecasting framework and can tie them together. A prior ICMgr|Spon = ICSpon|Spon (8)

article (Waring and Siegel 2003) provided a preliminary

jICMgr|Spon zMgr|Spon .

approach to forecasting alpha consisting simply of the

Equation 8 means that the expected information coeffi-

Grinold forecasting equation with minor adjustments to

cient of a fund manager in the view of the sponsor is the

adapt it to the problem of sponsors assessing the expected

product of the sponsor’s (self-assessed) skill at manager

alpha of managers:

evaluation, the standard deviation (cross-sectional) of

= ICSpon|Spon Mgr|Spon zMgr|Spon (7)

aMgr|Spon –Fees q fund manager information coefficients, and the z-score

Mgr . of the particular fund manager’s information coefficient

(in the view of the sponsor). This relationship explicitly

Equation 7 reads: “Expected alpha for a fund manager, incorporates both the sponsor’s skill level in assessing

in the view of the sponsor, is equal to the sponsor’s skill fund manager skill and the fund manager’s skill.

times the fund manager’s expected level of active risk,

Combining the two relationships, we substitute the spon-

times the unit normal z-score, zMgr|Spon , assigned

qtoMgr

the fund manager by the sponsor as an expression

sor’s estimate of the manager’s information coefficient,

ICMgr|Spon , from Equation 8 in place of the fund manager’s

of the sponsor’s view of that fund manager’s skill level,

self-estimated information coefficient, ICMgr|Mgr , into the

minus fees.”

fundamental law, Equation 5. This transfers the respon-

In practice, this forecasting equation seemed to produce sibility for the resulting estimate of the fund manager’s

reasonable results when used with the technology for alpha to the sponsor:

optimizing fund manager structure and budgeting fund

manager risk described earlier. Yet, we were convinced aMgr|Spon = ICMgr|Spon BrMgr|Spon

that it could be improved. For one thing, this formula Spon’s view (9)

of Mgr’s IC

clearly does not explicitly incorporate the two levels of

x TCMgr|Spon

required skill. For another thing, it does not incorporate q Mgr|Spon .

other known important variables, such as fund manager Writing Equation 9 out in full by using the righthand

breadth and the transfer coefficient. We anticipated fur- side of Equation 8, we get

ther developments; this article is the result.16

aMgr|Spon = ICSpon|Spon jIC zMgr|Spon

(

the fund manager’s forecasting skill, the information

Mgr|Spon (

Mgr|Spon IC (10)

coefficient, rather than the manager’s alpha as we did in

x BrMgr|Spon TCMgr|Spon Mgr|Spon .

the prior effort. And second, we make it so that whenever

q

a sponsor assesses fund manager skill, the methodology

17 The authors’ colleague and friend Ronald Kahn suggested this particular way to combine the two forecasting

equations, thereby cleverly and insightfully solving a problem that we had been working on for some time.

june 2008 11

Equation 10 has the happy benefit of reflecting the need The average z-score, taken across the universe of all

to quantify the sponsor’s skill at assessing manager market players, must be zero. The framework assumes

skill as well as incorporating both the breadth and the that fund manager skill, as with most other human skills,

transfer coefficient terms—all improvements to the first is distributed approximately normally but (unlike most

forecasting effort of Equation 7. human skills) with a mean of zero.18 Of course, assigning

a z-score of zero (for our average fund manager) would

Finally, parallel to the earlier effort, we subtract fees:

result in an estimate that this fund manager’s expected

= IC Spon|Spon zMgr|Spon

a Mgr|Spon j IC

Mgr|Spon

alpha is zero, less fees, which is consistent with a prior

belief that only the above-average fund manager can

x BrMgr|Spon TCMgr|Spon (11)

q Mgr|Spon be expected, before the fact, to succeed in the active

– FeesMgr|Spon . management game.

By moving beyond the averages and focusing on the

Equation 11 is our model of expected fund manager

individuals, however, sponsors can conceivably design

alpha in a complete form. This approach, which we

a set of criteria to assist in assigning z-scores, a kind of

refer to casually as the “Alpha-Builder,” involves seven

“fundamental analysis” approach to manager selection.

input variables, and all but two of them are relatively

A fund manager’s historical track record would no doubt

straightforward to estimate.

influence the assigned z-score, but other factors—such

as quality and perceived insight of the research team,

The Input Variables compensation structures, rigor of analytical processes,

We can provide some guidance in estimating values for

and generosity of research budgets—would be impor-

all seven input variables, although the fund manager’s

tant to most thoughtful sponsors. This area is fertile for

z-score and the sponsor’s own information coefficient

research by sponsors and fund-of-funds managers. Just

will always be the values that are most challenging.

as fund managers conduct research on factors that

Fund manager z-score (zMgr|Spon ). Fund manager predict security returns, successful sponsors will focus

z-scores are the most important input for forecasting on identifying factors that predict fund manager skill.

expected alpha, but at the same time, among the hardest

We see many sponsors attempt to reduce their selection

to assess. All but one of the other inputs are capable of

efforts to a repeatable process or “recipe.” An estimate of

being estimated via direct quantitative approaches, but

expected alpha, explicit or implicit, is likely to be worth-

the fund manager z-score usually depends on factors that

less, however, if it can be reduced to a recipe. That is, skill

are hard to quantify. They should be hard to judge, because

and judgment have to be in the mix somewhere, and the

the z-score is where the sponsor’s skill level is tested—if

use of a recipe inherently suggests that one is avoiding

assessing z-scores were easy, everybody could do it! And

the use of skill or judgment.19

if everybody could do it, there would be no alpha. Manager

z-scores are inherently subjective and require the sponsor

to exercise skillful and informed judgment.

18 One might argue that the mean is not zero for professional fund managers, but possibly positive as a result of a

categorical difference in skill between individual investors and professionals. Waring and Siegel (2003) suggested,

however, that if there is such a group effect, it is small, at least in the US, perhaps only 50 bps or so—not enough to

offset fees. Regardless of the argument, if an analyst thinks that the true mean for the relevant group of professional

fund managers is different from zero, the analyst should simply add the difference to the results from the framework.

19 The exception might be for effects that have not yet been generally discovered and that remain unincorporated in prices.

Many modern portfolio researchers look for such effects. Certain of these researchers may reduce their ideas to com-

puter code (i.e., recipes) in apparent violation of the prescription in the main text. However, the required judgment is

being exercised when the effect is chosen as a “signal” for the portfolio construction process, and each time the signal

is reviewed for continued inclusion. Moreover, over time, most such effects do become known, so the next opportunity

to exercise skill is deciding when to remove a given signal from the overall model. Most commonly repeated recipes

involve well-known ideas and are unlikely to be successful except by chance.

12 InvestmentInsights

Table 1 fund manager with an S&P 500 Index benchmark at an

relationship between fund manager active risk level of 5.0%, which is typical of a traditional

z-score and percentile rank

active manager who is at the first quartile of perfor-

Percentile rank Manager z-score mance.20 ) Obviously, there is some room to hope for

improvement in this estimate, particularly when dealing

2 –2.0

with managers of asset classes other than large-cap US

7 –1.5

equities. Until better data are available, however, we

16 –1.0 will use the 0.07 estimate for most benchmarks.

31 –0.5

Sponsor skill (IC Spon|Spon ) . This variable may be the

50 0.0

most difficult to assess of the seven in the model; it is

69 0.5

certainly one of the two most difficult to estimate (the

84 1.0 other being the z-score). IC Spon | Spon , the information

93 1.5 coefficient of the sponsor, in the sponsor’s own view,

98 2.0 is a quantification of the sponsor’s skill in picking good

active fund managers—or, more precisely, of the sponsor’s

skill in assessing the fund managers’ skill. IC Spon|Spon = 0

We have found percentiles to be more intuitive for many implies a before-fee expected alpha of zero, regardless

sponsors than raw z-scores when evaluating fund manag- of how high a z-score the sponsor may have given a

ers. Because z-scores are inherently normally distributed, particular fund manager: It means that the sponsor itself

a percentile rank can be easily translated into a z-score believes that its estimate of the manager’s z-score is no

by using standard probability tables. Table 1 indicates good and should not be used (so it will not be used because

that a fund manager thought by the sponsor to be at multiplying by IC Spon|Spon = 0 yields a before-fee expected

the 84th percentile can be understood by the analyst to alpha of zero, no matter what the other inputs are). In

have an assigned z-score of +1, whereas a fund manager other words, no matter how good the sponsor thinks a fund

assigned a 98th percentile rank can be interpreted as manager is, if the sponsor’s judgments are not believed—

having a z-score of +2. even by the sponsor—to have any predictive ability, they

are irrelevant and the sponsor should not expect any alpha.

Variability of fund manager skill (jICMgr|Spon

) . This

variable represents the cross-sectional standard deviation Estimating sponsor skill is a problem in self-assessment.

of skill (where skill is expressed as the information coef- It is difficult to do in any completely satisfactory manner

ficient) across the universe of generally similar active because the board, staff, and consultants involved in the

fund managers. Intuitively, one can understand that the process rarely have the data needed to demonstrate their

greater the variations in fund manager skill, the greater own statistically significant performance. In fact, the

the impact of sponsor skill in selecting a good manager— more completely they understand the problem, the more

thus, the greater the sponsor’s alpha expectations (even modest they may be in claiming special skill. But these

after being pared back by the action of the other terms people may be precisely the ones who have the greatest

of the forecasting approach). chance of winning the game.

There is no direct way to observe this standard deviation, We are not going to tell anyone how to estimate his or

but one can back into it inferentially. We believe that her own skill, but we would start by noting that if a

an estimate of 0.07 for is sensible, and we note given sponsor is playing the active manager selection

jIC

Mgr|Spon

that this value is consistent with large-capitalization US game, then it has also made an implied positive estimate

equity mutual fund data; we are currently using it and of its skill, IC Spon|Spon . The game leaves the sponsor no

have found that it gives reasonable estimates. (As shown room to be troubled by its inability to be certain about

in the first examples in the next section, this value pro- its own skill. The zero-sum game of active management

duces an information ratio of 0.50 for an active equity requires that one believe in oneself. Everyone and every

20 By “at the first quartile,” we mean at the break point between the top 25% of managers and the next 25%.

june 2008 13

group that has ever considered engaging in a sporting Win rates (which we will designate p, the probability of

event or other contest has faced the same uncertainty success) range from 0% to 100%; information coefficients,

in what are also usually zero-sum games, yet the games being correlation coefficients, range from –1 to +1. We

are never short of players. The zero-sum game of active can convert the win rates to the information coefficients

management, as for most other games, requires only that by using the following:

one believe in oneself if one is going to play, and this is

IC Spon|Spon " 2 p –1. (12)

expressed as a positive IC.

Thus, if the sponsor anticipates being right 67% of the

Rather than estimate sponsor skill directly, some might

time, IC Spon|Spon is fairly approximated as 0.34; if the win

prefer to use a boundary condition to substitute for it. For

rate is 50%, then, of course, IC Spon | Spon is 0.00. Table 2

example, a sponsor might say, “We estimate that in order

lays out this relationship. In the next section, we examine

to have a portfolio expected alpha that is positive and

the impact of various information coefficients.

valuable, after paying fund manager fees and experienc-

ing active fund management transaction costs, we need

an information coefficient of at least 0.33.”21 Table 2

estimating sponsor skill

Such a boundary is not in itself a proper estimate of

sponsor skill—far from it—but it represents a lower Sponsor success Sponsor skill

proportion (p) (ICSpon | Spon )

limit on the amount of skill a sponsor must have, given

the prior intent to hire active managers, in order to be 0% –1.0

successful. The sponsor may well decide that its skill 20 –0.6

level is higher than the minimum level required to make 40 –0.2

the hiring of active managers a rational choice. But if 60 0.2

the lower bound itself is used by the staff as its estimate 80 0.6

of IC Spon|Spon , using the Alpha-Builder process will have

100 1.0

the virtue of organizing fund manager expected alpha

estimates in a form that is consistent from one manager

to the next, putting them on a playing field leveled for Any degree of error introduced by misestimating the

costs, risks, breadth, and the transfer coefficient. Using sponsor’s information coefficient will, of course, affect

the lower bound is a start, from which one can proceed the results. An obvious example is that a sponsor mis-

to more sophisticated estimates if one chooses.22 takenly claiming an information coefficient of 0.30 but

Many sponsors will prefer to express their self-estimate having a true information coefficient of 0.00 will achieve

of skill as an expected future “win rate” rather than an a return that is randomly distributed around the bench-

information coefficient. For example, a sponsor might mark with a mean of zero, minus fees and costs.

say, “I think about two out of every three fund managers Furthermore, low sponsor information coefficients favor

that we pick, or 67%, will outperform.” This estimate can low-fee and low-tracking-error managers. As the sponsor’s

be used to approximate the information coefficient.23 own information coefficient approaches zero, the net

21 There is nothing special about this number; we are using it simply as an example. But given typical values for the

other inputs in Equation 11, it is in the right range.

22 In fact, if the sponsor truly has the skill that the board’s decision to be active presumes, this manner of backing into

an estimate of IC Spon|Spon will improve the sponsor’s results. And if the sponsor does not have skill, then the portfolio

will be no worse off in expectation than it would be in the absence of the estimate.

23 Note that the expected win rate only approximates sponsor skill. Consider two sponsors with the identical expected

win rate: Of the two, the one that overweights the best of its good managers clearly has more skill than the one that

assigns them all equal weights (the sponsor gets value from estimating not only the sign of the manager’s perfor-

mance but also the magnitude). Regardless, using the expected win rate should provide estimates of the information

coefficient that are in the right ballpark.

14 InvestmentInsights

expected alpha for the manager derived in our frame- because the sponsor lacks access to full information

work will begin to approach manager fees.24 In this case, about the portfolio’s construction and the reasoning

any optimizer will simply pick the managers with the behind it.) Few forecasts are completely independent,

lowest fees and lowest active risk—that is, index funds. and many (or most) are highly correlated. An active fund

This result should not be a surprise. A sponsor with no manager benchmarked to the S&P 500 might hold all

confidence in its ability to pick managers shouldn’t 500 stocks in her portfolio and might turn the portfolio

really be investing in active managers. over 200% per year, which would imply that she has

made 1,000 independent decisions. But breadth for this

Anyway, if a sponsor is going to play the great zero-

manager could easily be much less than 1,000 if the fore-

sum game of active manager selection, and play to win,

casts were driven by certain common factors and, there-

the sponsor must take responsibility for the critically

fore, are correlated—as is likely to be the case most of

important self-assessment embodied in its estimate of

the time. For example, fund managers may assign higher

IC Spon|Spon . Without doing so, and coming up positive,

expected alphas to stocks that have done well recently

a sponsor simply cannot justify hiring active managers.

ensure that their portfolios of fund managers are not

merely random collections of past winners and losers.

Fund manager breadth (Br Mgr|Spon ) . Breadth is the (a momentum factor) or stocks in the technology industry

number of statistically independent investment bets (an industry factor). In these examples, the fund manager

made by an active manager each year. Greater breadth is essentially making only one informed bet (on momen-

results in more diversification of the residual risk from tum or on an industry) despite appearing to follow all the

the active management effort and, all else being equal, stocks in the benchmark.

improves the consistency (reduces the standard devia-

Nonetheless, a safe point for the sponsor to start the

tion) of the fund manager’s performance. If that fund

estimation process is to assume that most fund manag-

manager has skill, such that his expected alpha is a

ers’ breadth is proportional to the product of the number

positive number, then as the standard deviation of the

of securities being actively evaluated times the annual

residual risk decreases, the percentage of the time

turnover.25 But because of the number of signals used

that the fund manager’s realized alpha is above zero

and their correlation, as discussed, this proportion is likely

increases. In the same way, the house in Las Vegas

to be considerably less than 1. And the sponsor should

operating a roulette wheel, with its tiny built-in house

certainly refine any such rough estimate by using any

advantage, is almost completely safe if it handles a mil-

information it can obtain regarding the fund manager’s

lion bets for a dollar each, but is taking an unacceptably

signals and portfolio construction techniques. The goal

high risk by handling one bet for $1 million.

is to meaningfully differentiate the fund managers from

Despite the simplicity of the concept, estimating breadth each other based on what they actually do.

in practice is not an exercise in precision, whether the

The transfer coefficient (TC Mgr|Spon ) . The transfer

estimate is being made by the manager or the sponsor.

coefficient, as already noted, reflects the impact of con-

(The sponsor has even more difficulty than the fund

straints on the portfolio’s performance. The most binding

manager in accurately estimating the manager’s breadth

24 F

ees are the only component of alpha that one can know for certain, and the fee amount does not require any estimate

of sponsor skill.

25 The

term “actively evaluated” keeps the emphasis on the number of securities that the manager follows and could

potentially hold rather than on the number of securities currently in the portfolio. The number in the portfolio might

underestimate breadth because a manager might omit a security from the portfolio simply to reflect a negative view.

june 2008 15

constraint on typical portfolios is the no-shorting restriction. because portfolios with higher active risks are also

It severely limits a fund manager’s ability to implement penalized by having lower transfer coefficients.)

negative views on securities and reduces the alpha

Active risk is perhaps the easiest variable to forecast. It

potential of the portfolio.

is much more stable than alpha and can be reasonably

We can estimate the transfer coefficient of long-only equity estimated from historical data (usually with an acceptable

portfolios by using an empirical result presented in Grinold degree of error, but there are exceptions). At the same

and Kahn (2000b). They conducted simulations to exam- time, the sponsor must be sure that the active risk it

ine the information ratios of optimal portfolios based on measures is estimated relative to the appropriate bench-

the same information but implemented with and without mark, or beta (or, usually, a mix of multifactor betas),

the long-only constraint. They measured the transfer one that represents the fund manager’s opportunity

coefficient related to the long-only constraint, denoted set and process.

TCLongOnly , at varying risk budgets and for various bench-

Many active fund managers have systematic style biases

marks, and they found that their results fit the following

(value, small cap, etc.) that differ from their stated bench-

polynomial expression well:

marks. A simple style analysis can identify the fund

1– g (N)

(1+

qMgr ) –1 manager’s actual average style during the study period,

1

TCLongOnly = , (13) and active risk should be measured relative to this bench-

q Mgr 1– g (N)

mark if it has been relatively stable. Doing so provides

for a clean separation of the beta and the alpha exposures

where g (N) = (53 + N)0.57 (it is simply a calibrating factor

and ensures that the sponsor is focusing on the “pure”

that they estimated empirically) and N is the number of

alpha and pure active risk (Waring and Siegel 2003).26

securities in the benchmark portfolio.

Fees (Fees Mgr|Spon ) . Ultimately, returns net of fees rep-

Equation 13 demonstrates that the two factors that act

resent the true value added by the fund manager, so the

to reduce the transfer coefficient most in a long-only

sponsor should measure and account for fund manager

portfolio are (1) a larger number of stocks in the bench-

fees somewhere in the process. Even a fund manager

mark (which reduces the average weight of the stocks

with skill will add no value to the sponsor if his fees are

and thus the amount by which the manager can express

equal to or higher than his expected alpha. For this rea-

a negative view by not holding a stock) and (2) greater

son, note that zMgr|Spon is evaluated on a before-fee basis

active risk in the portfolio (which increases the size of

in our formulation; fees are then subtracted explicitly

optimal active positions, which are then increasingly

by using a separate fee term.

constrained if negative). The most “efficient” funds,

then—those with the highest transfer coefficients—

will be those with low active risks that are operating

in fairly narrow markets.

Examples

To demonstrate the alpha-forecasting framework, we first

Active risk (

q Mgr|Spon ). The fund manager’s active risk,

or tracking error, represents the annualized standard

consider examples that illustrate the importance of sponsor

skill by comparing the alpha expectations for sponsors

deviation of the fund manager’s residuals, or alphas. If a with varying abilities in picking good fund managers.

positive value is assumed for manager skill, higher active Then, we consider examples that explore the effects

risk translates into a higher expected alpha. (The rela- of the transfer coefficient and of breadth.

tionship is not linear, however, for long-only portfolios,

26 Carrying out some sort of style analysis on fund managers will generally be better than using a simple benchmark

when separating alpha from beta. The biggest exception is for style rotators, tactical asset allocators, and those whose

styles are themselves the subject of intentional active bets and thus not stable over time. In such cases, style analysis

may not effectively add to one’s knowledge of the fund manager’s beta. Regression is not powerful enough in the pres-

ence of time-varying beta bets. Other means, usually subjective, must be used.

16 InvestmentInsights

Impact of Sponsor Skill Unfortunately most sponsors do not possess such

We start with a simple demonstration of the impact of remarkable forecasting abilities. In Case 2A, we consider

sponsor skill on alpha expectations. In these cases, a a sponsor with much lower, but still positive, skill,

sponsor has identified a long-only active fund manager a humble IC Spon|Spon = 0.10. This sponsor also thinks

benchmarked to the S&P 500 with 5.0% tracking error. the same fund manager is borderline top quartile and

The sponsor’s staff and consultant are impressed with assigns the same z-score of 0.67, as was assigned in

the fund manager’s thoughtfulness, training, insight, Case 1. So, with all inputs other than the information

and other characteristics (probably including past per- coefficient left unchanged, the estimated manager skill

formance!). The sponsor assigns the fund manager a is far lower than in Case 1 and, therefore, the expected

z-score of 0.67, a value indicating exactly borderline top- alpha is also far lower, at 0.24%. This sponsor knows

quartile skill (this figure is directly from the cumulative that it will often be wrong in its evaluation of fund

normal distribution table). Table 3 shows the evaluation manager skill (45% of the time, from Equation 12) and

of expected alpha from this manager in four sponsor sce- will thus hire many fund managers who turn out to be

narios, which vary as to the sponsor’s self-assessment duds. Thus, the sponsor’s overall realized alpha will,

of its own skill at assessing fund manager skill and in in fact, be lower, and its expectations should also be

the level of fees. In each case, breadth is assumed to be tempered in comparison with the prophetic sponsor

500 and the estimate of the transfer coefficient for the in Case 1 that picks only good fund managers.

S&P 500 benchmark comes from applying Equation 13.

The picture becomes grimmer for this sponsor if fees are

Case 1 represents a plan sponsor, perhaps King taken into account. Case 2B is the same as Case 2A except

Arthur’s Round Table, Inc.—one whose founding seer, that it assumes a modest fee of 0.25%. After subtracting

Merlin, still sits on the investment committee. With this fee, the net expected alpha becomes negative. Fees

an IC Spon| Spon = 1.0, this sponsor has perfect ability to raise the bar on successful active management. Despite

see the future for all fund managers. This clairvoyant the fact that this fund manager is expected to be more

sponsor can fairly predict a gross-of-fee expected alpha right than wrong (the manager has a positive information

of 2.43% from this fund manager, resulting in an infor- coefficient of 0.005 from Equation 8), a minimum degree

mation ratio of about 0.50.27 of manager skill is required to overcome the drag from

fees, and this one does not meet the minimum. If the

sponsor hires this manager, it must expect to lose

a small amount of money.

Table 3

impact of sponsor skill and fees on expected fund manager alpha

Inputs Output

Expected

Variability Transfer alpha net

Case Score Sponsor skill of IC Breadth Active risk (%) Fees (%) coefficient (%) of fees (%)

(z Mgr|Spon ) (IC Spon|Spon ) (jICMgr | Spon ) (BrMgr |Spon ) (qMgr |Spon ) (Fees Mgr|Spon) (TCMgr |Spon ) (aMgr |Spon )

1 0.67 1.00 0.07 500 5.0 0.00 46 2.43

2A 0.67 0.10 0.07 500 5.0 0.00 46 0.24

2B 0.67 0.10 0.07 500 5.0 0.25 46 –0.01

3 0.67 0.40 0.07 500 5.0 0.25 46 0.72

27 Of course, an all-seeing sponsor would pick a better manager if the case gave the sponsor a richer sample to choose

from; this manager is barely top quartile.

june 2008 17

Finally, Case 3 is an optimistic but not unrealistic sponsor number of securities in the benchmark, although that

that believes that for every 10 fund managers it chooses, is not necessarily the case. The assumption means

7 will be good, for a p = 0.70, which translates to an that for the same process, the portfolio benchmarked

IC Spon|Spon of 0.40. This sponsor is also paying fees of 0.25%, to the Russell 3000 has three times the breadth of

so the expected after-fee net alpha is 0.72%. Although one benchmarked to the Russell 1000. Both portfolios

this is nowhere near as large a number as many sponsor are run at identical 2.0% active risk by the same fund

professionals would claim if they were simply asked to manager, who the sponsor believes has borderline top-

“ballpark” an expected alpha for such a fund manager, quartile skill. The sponsor in this example is modestly

it is a figure that can stand up to a discussion on many confident of its abilities to spot good fund managers

fronts—all of which are intimately related to the limits and, based on an expected win rate of 7 out of 10,

of the possible for how much alpha can be expected from assigns itself a sponsor information coefficient of

a portfolio given the (fairly realistic) portfolio character- 0.4. For the time being, we ignore fees and again

istics and investment process that we have assumed. assume = 0.07.

jICMgr|Spon

These cases throw light on the importance of skill in active Table 4 reveals some of the tradeoffs associated with

management. Although sponsors and fund managers are increasing the portfolio’s breadth. An increase in breadth

tempted to make overly optimistic alpha forecasts (3% expands the opportunity set and thus increases the

and 4% forecasts of expected alpha will often be casually expected alpha of a portfolio in proportion to its square

bandied about), actual realized returns for the portfolio of root. Benchmarks with more securities have lower average

fund managers seldom reach such high levels. Skill levels security weights, however, and thus allow smaller nega-

need to be considered when setting expectations but usu- tive positions for long-only portfolios. This is the same

ally are not. Invariably, expectations become more modest as saying that the transfer coefficients of the resulting

when sponsors are fully informed by following the Alpha- portfolios are lower. Using Equation 13, we estimate a

Builder forecasting process that fully incorporates skill 44% transfer coefficient for Russell 3000–based active

estimates and other important variables. portfolios, in comparison with a 62% transfer coefficient

for a Russell 1000–based portfolio, where both have 2%

Impact of Increasing Breadth active risk. This unhelpful relationship between breadth

To examine some of the tradeoffs associated with and the transfer coefficient in long-only portfolios opposes

increasing breadth, we consider two long-only US equity the helpful first-order effect of greater breadth. The first-

portfolios: Portfolio A is benchmarked to the Russell order effect of increasing breadth, however, being larger

1000 Index (large cap only), whereas Portfolio B is than the negative effect of a decreasing transfer coefficient,

benchmarked to the Russell 3000 Index (in essence, does prevail. Thus, all other things being equal, Portfolio B,

the whole US market). In this example, we’ll make the benchmarked to the Russell 3000, has a higher expected

simplifying assumption that breadth is equal to the alpha than Portfolio A, benchmarked to the Russell 1000.

Table 4

impact of increasing breadth on expected alpha

Inputs Output

Expected

Variability Transfer alpha net

Portfolio Score Sponsor skill of IC Breadth Active risk (%) Fees (%) coefficient (%) of fees (%)

(z Mgr|Spon ) (IC Spon|Spon ) (jICMgr | Spon ) (BrMgr |Spon ) (qMgr |Spon ) (Fees Mgr|Spon) (TCMgr |Spon ) (aMgr |Spon )

A 0.67 0.40 0.07 1,000 2.0 0.20 62 0.53

B 0.67 0.40 0.07 3,000 2.0 0.20 44 0.71

18 InvestmentInsights

Table 5

impact of lower manager skill and higher breadth on expected alpha

Inputs Output

Expected

Variability Transfer alpha net

Portfolio Score Sponsor skill of IC Breadth Active risk (%) Fees (%) coefficient (%) of fees (%)

(z Mgr|Spon ) (IC Spon|Spon ) (jICMgr | Spon ) (BrMgr |Spon ) (qMgr |Spon ) (Fees Mgr|Spon) (TCMgr |Spon ) (aMgr |Spon )

A 0.67 0.40 0.07 1,000 2.0 0.20 62 0.53

B 0.50 0.40 0.07 3,000 2.0 0.20 44 0.48

The example becomes even more interesting if the spon- grasp. Certainly, alpha estimation cannot be done without

sor assigns Portfolio B a lower z-score, z Mgr|Spon , than grappling with estimating these variables at some level.

Portfolio A, reducing it to 0.50. This might be the case if

We have provided a rational means for scaling the two

the fund manager relies on fundamental analysis but is

most difficult inputs—fund manager skill and the plan

staffed with only a few analysts, so its resources become

sponsor’s skill at selecting fund managers—and incor-

thinner with increased breadth, resulting in a decline in

porating these estimates with other important factors,

forecasting accuracy. Table 5 shows the effect. Portfolio A

such as active risk levels, breadth, fees, and so on. The

remains the same as in Table 4. The result is a decline in

approach is reassuringly familiar, in that it is based

expected alpha to 0.48% for the revised Portfolio B, now

entirely on two bits of comfortably well-accepted alpha-

less than the 0.53% predicted for Portfolio A despite the

forecasting methods—the Grinold forecasting equation

benefit of Portfolio B’s much larger breadth.

and the fundamental law of active management.

Therefore, increased breadth is useful only if the fund

As with all mathematical formalizations of an inherently

manager can sustain forecasting accuracy and intensity

subjective decision-making process, the numerical answer

over a larger universe of securities—that is, if the increased

may not be as important as the process itself. The man-

breadth is, in fact, being used effectively.

ager evaluation framework suggested here is, therefore,

analogous to a discounted cash-flow valuation model for

security selection: The model forces the user to think

Conclusion clearly about the validity and internal consistency of his

The ability to forecast expected alpha is one of the keys

or her assumptions, and to communicate those assump-

to successfully employing active fund managers and

tions effectively among the user’s colleagues. Although

deserves much more attention by sponsors. Sponsors

the final manager selection decision may also involve

need to proactively forecast alpha to ensure that their

factors not discussed here, the quantitative process of

portfolios of fund managers are not merely random

this framework itself is inherently valuable.

collections of past winners and losers.

Before playing any game, it helps (a lot!) to know the rules

Forecasting alpha is hard, but it can be done. The Alpha-

of the game. For the negative-sum game of hiring fund

Builder framework described here helps organize the

managers, the rules require at least two levels of well-

effort logically. It identifies the variables that affect

above-average skill. As in any game, there will be winners

expected alpha, thus breaking up the estimation problem

and there will be losers. The good news for those who

into pieces that are easier to estimate than fund manager

desire to be winners is that simply understanding the

skill taken as a whole. These variables, including spon-

rules and using them to guide one’s actions can give

sor information coefficient, active risk, breadth, and the

one a tremendous advantage over the competition.

transfer coefficient, are within the sponsor’s estimation

june 2008 19

Appendix: We know that the slope of the regression line indicated by

The sponsor’s version of this value says something about the skill of the sponsor

the forecasting equation in assigning z-scores. We can see this point more clearly

Assume we have a set of next-period estimated z-scores if we decompose the fitted slope term into its natural

for n fund managers, z Mgr (n)|Spon , all of whom are under component terms of covariance over variance and then

consideration or already employed by the sponsor. These further simplify it:

z-scores are unit-normal predictions made by and “owned”

ICn=

jz IC

n, n

zn ;

by the sponsor about how good each particular fund man- 2 (A3)

ager will be [here, z Mgr (n)|Spon , is simplified to z n ].

jz n

fund manager’s actual, realized skill in the next period, zn

ICn= (rz )( ) (A4)

or IC Mgr (n)|Spon (simplified here to ICn). We will tease the n,

IC

n j IC

n

jz n

required methodology out of the mathematics of regres-

sion analysis. The first term on the right in Equation A4, rz IC , is the

n, n

correlation between the sponsor’s forecast z-scores and

If we regressed the realized information coefficients of

the realized information coefficient of the manager, ICn .

the managers on the z-scores predicted by the sponsors

In our notation in the main text, this term is simply the

(we probably would not actually do this, but we could),

information coefficient of the sponsor itself, IC Spon|Spon .

we would be taking advantage of a relationship that has

The second term, IC , is also already in our notation as

the form j n

the cross-sectional variation in manager information

ICn= a + bzn+

en , (A1) coefficient, notated in the main text as

jIC

Mgr|Spon

. And

because z is a normalized variable, z = 1 by construc-

which means that the next-period realized information

tion, so the final term is simply zn .

j n

regression intercept, a, plus the product of the fitted slope, With these understandings, Equation A4 can be restated

b, times the sponsor’s estimated z-score for the manager, in the general form of the familiar forecasting equation but

plus or minus an error term. If the average information in a way that reflects its change in focus from estimating

coefficient and average z-score are both zero, consistent security alphas to estimating manager information coef-

with our understanding that this is a zero-sum game, then ficients. Going back to fully subscripted notation to avoid

a is also zero; we will make this assumption and will drop ambiguity, we have

the a term out of the equation.

IC Mgr|Spon = IC Spon|Spon zMgr|Spon . (A5)

The regression equation makes obvious the imperfections

jIC Mgr|Spon

in the forecast, of course: The realized information coeffi-

ficient of the manager, in the view of the sponsor, is the

cients will include this pesky error term. But because the

information coefficient of the sponsor itself, times the cross-

error term itself has a zero expectancy by construction,

sectional volatility of manager skill, times the z-score of

we can drop it when considering our best estimate of (or

the manager as estimated by the sponsor. It is Equation

the expected) information coefficient. With this simpli-

8 in the main text, a fund manager–oriented version of

fication, we see that the best estimate of the next-period

the security-centric forecasting equation (compare with

information coefficient of the nth manager is really simply

Equation 6) presented in Grinold (1994) and Grinold and

the slope term, b, times the z-score given the manager:

Kahn (2000a), both of which are worthy of rereading for

ICn= bzn . (A2) their many wise insights about alpha.

20 InvestmentInsights

References Siegel, Laurence B. 2004. “Distinguishing True Alpha

Clarke, Roger, Harindra de Silva, and Steven Thorley. from Beta.” In Points of Inflection: New Directions for

2002. “Portfolio Constraints and the Fundamental Law Portfolio Management. Charlottesville, VA: CFA Institute.

of Active Management.” Financial Analysts Journal 58,

Statman, Meir, Steven Thorley, and Keith Vorkink. 2006.

no. 5 (September/ October).

“Investor Overconfidence and Trading Volume.” Review

Grinold, Richard C. 1989. “The Fundamental Law of Active of Financial Studies 19, no. 4 (Winter).

Management.” The Journal of Portfolio Management 15,

Waring, M. Barton, and Laurence B. Siegel. 2003.

no. 3 (Spring).

“Understanding Active Management.” Investment

Grinold, Richard C. 1994. “Alpha Is Volatility Times IC Insights 6, no. 1 (April), San Francisco: Barclays Global

Times Score.” The Journal of Portfolio Management 20, Investors. Republished in two parts as “The Dimensions

no. 4 (Summer). of Active Management,” The Journal of Portfolio

Grinold, Richard C., and Ronald N. Kahn. 2000a. Active Management 29, no. 3 (Spring 2003) and “Debunking

Portfolio Management, 2nd ed. New York: McGraw-Hill. Some Myths of Active Management,” The Journal of

Investing 4, no. 2 (Summer 2005).

Grinold, Richard C., and Ronald N. Kahn. 2000b.

“Efficiency Gains of Long–Short Investing.” Financial Waring, M. Barton, Duane Whitney, John Pirone, and

Analysts Journal 56, no. 6 (November/December). Charles Castille. 2000. “Optimizing Manager Structure

and Budgeting Manager Risk.” The Journal of Portfolio

Kahn, Ronald N. 2000. “Most Plan Sponsors Need More

Management 26, no. 3 (Spring).

Enhanced Indexing.” In Enhanced Indexing: New Strategies

and Technique for Investors, edited by Brian R. Bruce.

New York: Institutional Investor, Inc.

Profit When All Traders Are Above Average.” The Journal

of Finance 53, no. 6 (December).

American Economic Review 89, no. 5 (December).

Management.” Financial Analysts Journal 47, no. 1

(January/February).

june 2008 21

Investment Insights

Published by Barclays Global Investors

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San Francisco, ca 94105

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